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Currency volatility may bring unwelcome surprise for some firms

INSIGHT ARTICLE
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December 11, 2014

Joe Brusuelas, Faye Miller, Monique Cole

Over the past several weeks I have addressed both American and European audiences on the global economic outlook. During that journey several middle market leaders shared that they are considering making large capital investments and expanding operations, which is a promising sign for the 2015 economic outlook. Not surprisingly, I also received many questions about the risks associated with those investments due to U.S. dollar appreciation/euro depreciation and volatility in currency markets.

As the U.S. Federal Reserve exits its asset purchase program while the European Central Bank and Bank of Japan both expand theirs, policy divergences among major central banks and differentials in growth and interest rate expectations between the U.S. and the G-20, have roiled foreign exchange markets. The U.S. dollar is up 12 percent against the euro since March and has appreciated 5 percent against a trade-weighted basket of currencies since February.

Source: McGladrey, U.S. Federal Reserve

Reduced reliance on imported oil is shrinking the U.S. current account deficit and an improved fiscal position, thanks to increased tax revenues as a result of faster growth, has altered the perceptions of investors about the underlying value of the dollar. The changes in these economic fundamentals, along with the period of divergence ahead between the U.S. and other major central banks in monetary policy, growth and interest rates, should lead to a sustained period of dollar strength against major trading partners.

While an increase in the purchasing power of domestic households and firms bodes well for the middle market, it implies that firms with transactional exposure associated with currency volatility, or changing terms of trade which may result in a loss of competitiveness, should begin thinking about how to hedge. Given rapidly changing global economic conditions, middle market firms might want to consider approaching the purchase of effective hedges against currency volatility in the same way households purchase auto, homeowners, life or rental insurance. It’s a necessary expense that one pays for with the intent of never having to use it. The inherent volatility of foreign exchange markets and the changes afoot in the global economy suggest that purchasing a little peace of mind is prudent and rational.

Different techniques to hedge transaction exposure are easily understood if placed into three categories:

Forward Contracts: In most developed markets, a firm can purchase a contract specifying a price at which it can sell or buy a currency in the future. This entails a simple contract that states one firm has agreed to pay/receive a fixed amount of foreign currency at a specific date in the future. The logic of this approach, which many small or medium size firms will likely prefer, exchanges the ex-post value of the domestic currency of the liability or asset into a precisely defined value that will be delivered on a certain date despite the prospect of foreign exchange volatility during the life of the contract. This derivative instrument is not traded on an exchange.

Futures Contracts: While similar to a forward contract, this instrument is different in that it is traded in liquid secondary markets on an exchange and often appeals to larger firms with greater appetites for risk in volatility currency and commodity markets. Because futures contracts are only available in specific currencies, maturities and size, it isn’t typically possible to purchase a position that completely eliminates exposure . Exchanges function as an intermediary between two parties that have entered into a transaction to buy or sell a quantity of goods, currency or financial instruments at an agreed upon price on a specified future date. The firm agreeing to be the “buyer” of the contract is said to be “long” and the firm selling the asset on the specified date is said to be “short.” On the agreed upon closing date, the contract is marked to market using the spot value of the good or currency with any gains or losses accruing to the party “in the money.”

Options: This is a straightforward financial instrument that gives the purchaser, for an explicit price, the right but not the obligation to trade domestic/foreign currency for foreign/domestic currency at a precise quantity and price during a specified time interval. While there are several types of options, they generally permit the removal of downside risk while retaining the benefit of financial gains, which are unlike forwards, futures or synthetic forward contracts. Like futures contracts, options generally appeal to larger firms with greater appetite for risk or those that purchase commodities used at earlier stages of production.

So how should a chief financial officer or a corporate treasurer convert this information into action? First, the choice of instruments should be tied to the firm’s risk profile. For example, is the firm aiming to transform variable into fixed, thus giving away upside for certainty, or is the firm willing to “swing with the market” to a degree, and therefore considering an option approach to protect that downside? Suppose the primary firm decision-maker is worried about the uncertainty of submitting a fixed bid in foreign currency in a futures contract amid the possibility of potential losses. Then one alternative approach would be to purchase an option, which would protect the value of cash flows against adverse movements in currency markets. The decision matrix under those conditions would be as follows:

If the spot price outperforms the option price, the CFO should consider letting the option expire. If the option outperforms the spot price at the specified delivery date, then the CFO may wish to consider exercising it.

In addition to understanding the economic ramifications associated with any decision to hedge, it’s prudent to understand how proposed transactions will be reflected in the financial statements. Such upfront consideration can go a long way toward ensuring that a hedge that is economically effective doesn’t cause unanticipated income statement volatility.

Accounting standards (namely, the Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging, known as ASC 815, ) require derivatives such as the forward, futures and options contracts described above to be accounted for on the balance sheet at fair value. If hedge accounting is not elected and applied, changes in the fair value of the derivatives are recognized through the income statement and can therefore cause significant income statement volatility from one period to the next. Generally, income statement volatility can be minimized if a firm elects and qualifies for hedge accounting in the form of either a cash flow hedge, fair value hedge or hedge of a net investment in a foreign operation.

There are stringent requirements that must be met to elect and qualify for hedge accounting including concurrent designation and documentation of the hedge in a very prescriptive manner as well as demonstrating that the hedge is highly effective in accordance with the requirements of ASC 815.

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